BIWS DCF EXAM WITH
100% CORRECT
ANSWERS
How do you interpret the results of a DCF? - Answer-You compare the company's
Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value,
Equity Value, or Share Price to see if it might be overvalued or undervalued.
You do this over a range of assumptions because investing is probabilistic.
For example, if you believe that the company's Implied Share Price is between $15.00
and $20.00, but its Current Share Price is $8.00, then that is good evidence that the
company may be undervalued.
But if its Current Share Price is $17.00, then it may be valued appropriately.
Does a DCF ever make sense for a company with negative cash flows? - Answer-Yes, it
may. A DCF is based on a company's expected future cash flows, so even if the
company is cash flow-negative right now, the analysis could work if it starts generating
positive cash flows in the future.
If the company has no path to positive cash flows, or you can't reasonably forecast its
cash flows, then the analysis doesn't make sense.
How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ
from the Unlevered DCF? - Answer-In a Levered DCF, you use Levered FCF for the
cash flows and Cost of Equity for the Discount Rate, and you calculate Terminal Value
using Equity Value-based multiples such as P / E.
You don't back into Implied Equity Value at the end because the analysis produces the
Implied Equity Value directly.
An APV Analysis is similar to a traditional Unlevered DCF, but you value the company's
Interest Tax Shield separately and add the Present Value of this Tax Shield at the end.
You still calculate Unlevered FCF and Terminal Value in the same way, but you use
Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk
Premium * Median Unlevered Beta from Public Comps).
,You then project the Interest Tax Shield each year, discount it at that same Discount
Rate, calculate the Interest Tax Shield Terminal Value, discount it, and add up
everything at the end.
Will you get the same results from an Unlevered DCF and a Levered DCF? - Answer-
No. The simplest explanation is that an Unlevered DCF does not factor in the interest
rate on the company's Debt, while the Levered DCF does.
That alone will create differences, but the volatile cash flows in a Levered DCF (due to
changes in Debt principal) will also contribute; it's very difficult to pick "equivalent
assumptions" in both analyses.
Why do you typically use the Unlevered DCF rather than the Levered DCF or APV
Analysis? - Answer-The traditional Unlevered DCF is easier to set up, forecast, and
explain, and it produces more consistent results than the other methods.
With the other methods, you have to project the company's Cash and Debt balances,
Net Interest Expense, and changes in Debt principal, all of which require more time and
effort.
The Levered DCF sometimes produces odd results because Debt principal repayments
can spike the Levered FCF up or down in individual years.
The APV Analysis is flawed because it doesn't factor in the main downside of Debt:
Increased chances of bankruptcy. You can try to reflect this risk, but no one agrees on
how to estimate it numerically.
The Unlevered DCF solves this issue because WACC decreases with additional Debt,
at first, but then starts increasing past a certain level, which reflects both the
advantages and disadvantages of Debt.
Why do you calculate Unlevered Free Cash Flow by including and excluding various
items on the financial statements? - Answer-Unlevered FCF must capture the
company's core, recurring line items that are available to ALL investor groups.
That's because Unlevered FCF corresponds to Enterprise Value, which also represents
the value of the company's core business available to all investor groups.
So, if an item is NOT recurring, NOT related to the company's core business, or NOT
available to all investor groups, you leave it out.
This rule explains why you exclude all of the following items:
• Net Interest Expense - Only available to Debt investors.
• Other Income / (Expense) - Corresponds to non-core-business Assets.
• Most non-cash adjustments besides D&A - They're non-recurring.
• All Items in Cash Flow from Financing - They're only available to certain investors.
• Most of Cash Flow from Investing - Only CapEx is a recurring, core-business item.
How does the Change in Working Capital affect Free Cash Flow, and what does it tell
you about a company's business model? - Answer-The Change in Working Capital tells
you whether the company generates more cash than expected as it grows, or whether it
requires more cash to fuel that growth.
It's related to whether a company records expenses and revenue before or after paying
or collecting them in cash.
, For example, retailers tend to have negative values for the Change in Working Capital
because they must pay for Inventory upfront before they can sell products.
But subscription-based software companies often have positive values for the Change
in Working Capital because they collect cash from long-term subscriptions upfront and
recognize it as revenue over time.
The Change in WC could increase or decrease the company's Free Cash Flow, but it's
rarely a major value driver because it's fairly small for most companies.
Should you add back Stock-Based Compensation to calculate Free Cash Flow? It's a
noncash add-back on the Cash Flow Statement. - Answer-No! You should consider
SBC a cash expense in the context of valuation because it creates additional shares
and dilutes the existing investors.
By contrast, Depreciation & Amortization relate to timing differences: The company paid
for a capital asset earlier on but recognizes that payment over many years.
Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but
the context is different: Accounting rather than valuation.
In a DCF, you should count SBC as a real cash expense or, if you count it as a non-
cash add-back, you should reflect the additional shares by increasing the company's
diluted share count, which will reduce the Implied Share Price.
Most DCFs get this completely wrong because they use neither approach: They pretend
that SBC is a normal non-cash charge that makes no impact on the share count
(wrong!).
What's the proper tax rate to use when calculating FCF - the effective tax rate, the
statutory tax rate, or the cash tax rate? - Answer-The company's Free Cash Flows
should reflect the cash taxes it pays.
So, it doesn't matter which rate you use as long as the cash taxes are correct.
For example, you could use the company's effective tax rate (Income Statement Taxes /
Pre-Tax Income), and then include Deferred Taxes within the non-cash adjustments.
Or you could calculate and use the company's "cash tax rate" and skip the Deferred Tax
adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes
and other items to arrive at the company's real cash taxes.
It's most common to use the effective tax rate and then adjust for Deferred Taxes based
on historical trends.
What's the point of valuation? WHY do you value a company? - Answer-You value a
company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company's Current Value, you might be
able to invest in the company and make money if its value changes.
If you are advising a client company, you might value it so you can tell management the
price that it might receive if the company sells, which is often different from its Current
Value.
100% CORRECT
ANSWERS
How do you interpret the results of a DCF? - Answer-You compare the company's
Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value,
Equity Value, or Share Price to see if it might be overvalued or undervalued.
You do this over a range of assumptions because investing is probabilistic.
For example, if you believe that the company's Implied Share Price is between $15.00
and $20.00, but its Current Share Price is $8.00, then that is good evidence that the
company may be undervalued.
But if its Current Share Price is $17.00, then it may be valued appropriately.
Does a DCF ever make sense for a company with negative cash flows? - Answer-Yes, it
may. A DCF is based on a company's expected future cash flows, so even if the
company is cash flow-negative right now, the analysis could work if it starts generating
positive cash flows in the future.
If the company has no path to positive cash flows, or you can't reasonably forecast its
cash flows, then the analysis doesn't make sense.
How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ
from the Unlevered DCF? - Answer-In a Levered DCF, you use Levered FCF for the
cash flows and Cost of Equity for the Discount Rate, and you calculate Terminal Value
using Equity Value-based multiples such as P / E.
You don't back into Implied Equity Value at the end because the analysis produces the
Implied Equity Value directly.
An APV Analysis is similar to a traditional Unlevered DCF, but you value the company's
Interest Tax Shield separately and add the Present Value of this Tax Shield at the end.
You still calculate Unlevered FCF and Terminal Value in the same way, but you use
Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk
Premium * Median Unlevered Beta from Public Comps).
,You then project the Interest Tax Shield each year, discount it at that same Discount
Rate, calculate the Interest Tax Shield Terminal Value, discount it, and add up
everything at the end.
Will you get the same results from an Unlevered DCF and a Levered DCF? - Answer-
No. The simplest explanation is that an Unlevered DCF does not factor in the interest
rate on the company's Debt, while the Levered DCF does.
That alone will create differences, but the volatile cash flows in a Levered DCF (due to
changes in Debt principal) will also contribute; it's very difficult to pick "equivalent
assumptions" in both analyses.
Why do you typically use the Unlevered DCF rather than the Levered DCF or APV
Analysis? - Answer-The traditional Unlevered DCF is easier to set up, forecast, and
explain, and it produces more consistent results than the other methods.
With the other methods, you have to project the company's Cash and Debt balances,
Net Interest Expense, and changes in Debt principal, all of which require more time and
effort.
The Levered DCF sometimes produces odd results because Debt principal repayments
can spike the Levered FCF up or down in individual years.
The APV Analysis is flawed because it doesn't factor in the main downside of Debt:
Increased chances of bankruptcy. You can try to reflect this risk, but no one agrees on
how to estimate it numerically.
The Unlevered DCF solves this issue because WACC decreases with additional Debt,
at first, but then starts increasing past a certain level, which reflects both the
advantages and disadvantages of Debt.
Why do you calculate Unlevered Free Cash Flow by including and excluding various
items on the financial statements? - Answer-Unlevered FCF must capture the
company's core, recurring line items that are available to ALL investor groups.
That's because Unlevered FCF corresponds to Enterprise Value, which also represents
the value of the company's core business available to all investor groups.
So, if an item is NOT recurring, NOT related to the company's core business, or NOT
available to all investor groups, you leave it out.
This rule explains why you exclude all of the following items:
• Net Interest Expense - Only available to Debt investors.
• Other Income / (Expense) - Corresponds to non-core-business Assets.
• Most non-cash adjustments besides D&A - They're non-recurring.
• All Items in Cash Flow from Financing - They're only available to certain investors.
• Most of Cash Flow from Investing - Only CapEx is a recurring, core-business item.
How does the Change in Working Capital affect Free Cash Flow, and what does it tell
you about a company's business model? - Answer-The Change in Working Capital tells
you whether the company generates more cash than expected as it grows, or whether it
requires more cash to fuel that growth.
It's related to whether a company records expenses and revenue before or after paying
or collecting them in cash.
, For example, retailers tend to have negative values for the Change in Working Capital
because they must pay for Inventory upfront before they can sell products.
But subscription-based software companies often have positive values for the Change
in Working Capital because they collect cash from long-term subscriptions upfront and
recognize it as revenue over time.
The Change in WC could increase or decrease the company's Free Cash Flow, but it's
rarely a major value driver because it's fairly small for most companies.
Should you add back Stock-Based Compensation to calculate Free Cash Flow? It's a
noncash add-back on the Cash Flow Statement. - Answer-No! You should consider
SBC a cash expense in the context of valuation because it creates additional shares
and dilutes the existing investors.
By contrast, Depreciation & Amortization relate to timing differences: The company paid
for a capital asset earlier on but recognizes that payment over many years.
Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but
the context is different: Accounting rather than valuation.
In a DCF, you should count SBC as a real cash expense or, if you count it as a non-
cash add-back, you should reflect the additional shares by increasing the company's
diluted share count, which will reduce the Implied Share Price.
Most DCFs get this completely wrong because they use neither approach: They pretend
that SBC is a normal non-cash charge that makes no impact on the share count
(wrong!).
What's the proper tax rate to use when calculating FCF - the effective tax rate, the
statutory tax rate, or the cash tax rate? - Answer-The company's Free Cash Flows
should reflect the cash taxes it pays.
So, it doesn't matter which rate you use as long as the cash taxes are correct.
For example, you could use the company's effective tax rate (Income Statement Taxes /
Pre-Tax Income), and then include Deferred Taxes within the non-cash adjustments.
Or you could calculate and use the company's "cash tax rate" and skip the Deferred Tax
adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes
and other items to arrive at the company's real cash taxes.
It's most common to use the effective tax rate and then adjust for Deferred Taxes based
on historical trends.
What's the point of valuation? WHY do you value a company? - Answer-You value a
company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company's Current Value, you might be
able to invest in the company and make money if its value changes.
If you are advising a client company, you might value it so you can tell management the
price that it might receive if the company sells, which is often different from its Current
Value.
